Posted on September 24, 2009 by Jerald David August

Chief Counsel's Office Issues Memorandum Treating Lending Activities Undertaken by Foreign Corporations Through U.S. Agent As Effectively Connected Income (CC:Intl:BR5)(9/22/09)

In a move designed to thwart efforts to have offshore loan originators and purchases of U.S. debt portfolios, such as consumer debt or subprime mortgages, from avoiding effectively connected income per §864(b), the Office of Chief Counsel addressed the question of whether interest income earned by a foreign corporation with respect to loans originated by an agent, whether dependent or independent, operating in the United States is attributable to "the U.S. office" through which the foreign corporation’s banking, financing or similar business activity is carried on, such that the interest income is "effectively connected income"?

The CCO Memorandum concludes that received by a foreign corporation with respect to loans that it originated to U.S. borrowers constitutes income effectively connected with such foreign corporation’s banking, financing or similar business when an agent, whether dependent or independent, performs origination activities described in the facts below on the foreign corporation’s behalf with respect to such loans in the United States.

 

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Posted on September 22, 2009 by Jerald David August

Service Releases Notice 2009-78, 2009-40 IRB 1 To Thwart Efforts to Avoid the Application of the Anti-Inversion Rules under Section 7874

As previously reported, the IRS published in June, 2009, temporary and proposed regulations to §7874 which modified an example contained in former Temp.Reg. §1.7874-2T(e)(5), Ex.3 that may have created an unintended or unforeseen method of avoiding the 80% stock ownership test under §7874(b).

The Notice states that the IRS and Treasury have become aware of transactions intended to avoid §7874 that involve a transfer of cash or other assets to the foreign corporation in a transaction related to the acquisition described in §7874(a)(2)(B)(i). The transaction minimizes the former shareholders' ownership in the foreign corporation for purposes of falling short of the 80% stock ownership condition. Similar transactions may be structured for the acquisition of a domestic corporation in a bankruptcy reorganization or a case involving a domestic partnership. Also of concern is the possible exploitation of the public offering rule of §7874(c)(2)(B) which applies to all public issuances of stock by a foreign corporation, regardless of the property exchanged for the stock.

A so-called corporate "inversion" transaction involves the restructuring of a U.S. based group of corporations, frequently engaged in multinational operations, so that a newly organized foreign corporation, generally organized in a tax haven or low tax jurisdiction, becomes the parent corporation of the prior U.S. parent corporation and group of subsidiaries. An inversion transaction can be effectuated through the movement of stock or assets, or a combination of both. For example, a stock inversion would involve a parent U.S. corporation forming a new foreign corporation which forms a domestic acquisition subsidiary. The U.S. subsidiary is merged into the U.S. parent corporation surviving as the first tier subsidiary of the foreign parent. The U.S. parent corporation's shareholders exchange their shares of U.S. (parent) stock for shares of the foreign corporation. An asset inversion achieves the same result but through direct merger of the parent US. corporation into a new foreign corporation. Further restructuring efforts could involve moving U.S. subsidiaries into a foreign grouping.

Prior to the enactment of §7874, inversions had the potential to cause immediate U.S. income taxation to the shareholders exchanging U.S. for foreign parent shares in accordance with §367(a). The transfer of foreign subsidiaries or other assets to the foreign parent corporation also may trigger income taxation for U.S. purposes at the corporation level. With an asset inversion, e.g., direct merger approach, the transferor U.S. parent corporation generally has gain (but not loss) recognition in accordance with §368 and relations. After the inversion is completed, foreign source income of foreign companies are outside of the jurisdiction of the U.S. tax authorities. This reduction in U.S. income tax liability can be further reduced by other earnings stripping strategies involving payment s of deductible amounts of interest, rents, management service fees or royalties, subject to certain policing rules.

Section 7874 was enacted to eliminate the major tax benefits of an inversion involving "expatriated entities," including either a domestic corporation or domestic partnership with respect to which a foreign corporation is a "surrogate foreign corporation," or a company related to such a domestic corporation or partnership. More particularly, a surrogate foreign corporation is a foreign corporation that acquires, directly or indirectly, substantially all of the properties held directly or indirectly by a domestic corporation if at least 60% of the foreign corporation's stock (by vote or value) after the acquisition is held by former shareholders of the domestic corporation by reason of holding its stock. As to a domestic partnership, a surrogate foreign corporation includes a foreign corporation that acquires, directly or indirectly, substantially all of the properties of a trade or business of a domestic partnership if at least 60% of the foreign corporation's stock (by vote or value) after the acquisition is held by former partners of the domestic partnership by reason of holding a capital or profits interest. Regardless, a foreign corporation is a surrogate foreign corporation only if, after the acquisition, the "expanded affiliated group" (EAG) does not have "substantial business activities" in the foreign country in which, or under the law of which, the foreign corporation is created or organized, when compared to the total business activities of the EAG.

If §7874 applies, the "foreign corporation" is nevertheless treated as a domestic corporation for U.S. federal income tax purposes regardless of local in which it is organized or managed, provided at least 80% or more of its stock is owned by former shareholders of the now "inverted" domestic corporation. Alternatively, where only 60% or more of the stock is owned by former shareholders of the inverted domestic corporation, then the underlying inversion transaction is respected so that the foreign parent is not "domesticated", but during the ten-year period following the inversion transaction, any applicable gain or income recognition required as a result of the inversion can not be offset by the group’s favorable tax attributes to mitigate the extent of the gain.

Under §7874(c)(2), certain shares of stock of a foreign corporation are ignored in determining whether the ownership tests are met:(i) stock of the foreign corporation held by members of the expanded affiliated group that includes the foreign corporation, and (ii) stock of the foreign corporation sold in a public offering related to the acquisition described in §7874(a)(2)(B)(i). Regulations on the ownership tests were published in 2008 and later in 2009. TD 9399; TD 9453. See §7874(g) which grants the Secretary broad powers to regulate in this area and prevent avoidance. See also §7874(c)(6) as well which permits the issuance of regulations to determine whether a corporation is a surrogate foreign corporation, including regulations to treat stock as not stock.

In TD 9453, the IRS and Treasury modified § 1.7874-2T(e)(5), Example 3, to eliminate an unintended benefit flowing from the public offering rule of §7874(c)(2)(B).

In Notice 2009-78, supra, the Service acknowledged the presence of transactions planned to avoid §7874 which involve a transfer of cash (or certain other assets) to the foreign corporation in a transaction related to the acquisition described in §7874(a)(2)(B)(i), thereby minimizing the former shareholders' ownership in the foreign corporation to fall below the 80% threshold. In one such transaction, for example, the shareholders of a domestic corporation (DC) transfer all their DC stock to a newly-formed foreign corporation (New FCo) in exchange for 79% of the stock of New FCo and, in a related transaction, an investor transfers cash to New FCo in exchange for the remaining 21 percent of the New FCo stock. Some are of the view that the New FCo stock issued to the investor is not "sold in a public offering" and thus is not subject to §7874(c)(2)(B). It was also stated in the Notice that the IRS and Treasury understand that similar transactions may be structured with respect to the acquisition of a domestic corporation in a title 11 or similar case (as defined in §368(a)(3)) or a domestic partnership.

The IRS and Treasury also understand that taxpayers are concerned the public offering rule of section 7874(c)(2)(B) applies to all public issuances of stock by a foreign corporation, regardless of the property exchanged for the stock. For example, assume that, pursuant to a business combination, the shareholders of a publicly-traded foreign corporation (FT) and a publicly-traded domestic corporation (DT) intend to transfer their FT and DT stock, respectively, to a newly-formed foreign corporation (FA) that will be publicly-traded. To effectuate the transaction, as part of a plan FA acquires all of the FT and the DT stock, respectively, from the FT and DT shareholders in exchange solely for newly-issued FA stock. If the FA stock issued to the FT shareholders is considered "sold in a public offering" and thus subject to §7874(c)(2)(B), the former shareholders of DT would be treated as owning 100% of the stock of FA for purposes of the ownership of stock requirement, and FA would therefore be treated as a domestic corporation for purposes of the Code under §7874(b). A similar result would occur if instead FT merged with and into FA and the FT shareholders exchanged their FT stock for FA stock pursuant to the merger. The IRS and Treasury believe that such a result could be inappropriate in certain cases.

In the Notice, the IRS and Treasury intend to issue regulations identifying stock of the foreign corporation that is not taken into account for purposes of the ownership test. Suchregulations will provide that stock of the foreign corporation issued in exchange for "nonqualified property" in a transaction related to the acquisition described in §7874(a)(2)(B)(i) will not be counted for under the stock ownership condition regardless of whether such stock is publicly traded on the date of issuance or otherwise. The regulations will also address other issues to prevent end runs on §7874.

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Posted on September 10, 2009 by Jerald David August

Tax Court Rejects Qualified Intermediary Exchange With a Related Party as a Tax-Free Exchange Under Section 1031 in Ocumulgee Fields v. Commissioner, 132 T.C. No. 6 (2009).

The Tax Court in Ocumulgee Fields stated it was not ruling, as a matter of law, that a finding of basis shifting precludes the absence of a principal purpose of tax avoidance, but, in the case at hand, the immediate tax consequences resulting from petitioner's deemed exchange resulted in a $1.8 million reduction in taxable gain and the substitution of a 15% tax rate for a 34% tax rate. Still, the Ocumulgee Fields and Teruya Bros. decisions make it difficult to find a more likely than not basis to qualify a related party exchange through a QI particularly in instances where the related party already owned the replacement property.

The Tax Court’s recent decision in Ocumulgee Fields v. Commissioner, places great stress on the ability of a taxpayer to successfully structure a related party exchange under §1031(f) where the related party transfers the replacement property to the taxpayer through a qualified intermediary. The hurdle is the non-tax avoidance prohibition set forth in §1031(f)(4). Ocmulgee Fields is an important development because it highlights the potential tax risk in acquiring replacement property from a related party. After the Tax Court’s prior decision to the same effect in Teruya Brothers, it was not necessarily clear that the acquisition of replacement property from a related party would, in general, be viewed as "abusive" within the meaning of section 1031(f)(4) .The judicial analysis set forth in Ocmulgee Fields confirms what some had suspected that most acquisitions of replacement property from a related party may be "bad" exchanges and will not qualify for tax free treatment.

As many tax advisors know, §1031(a)(1) provides that no gain or loss is recognized with respect to an "exchange" of property of like-kind. Certain properties described in a parenthetical clause to §1031(a), such as interests in a partnership, stocks or securities, inventory, choses in action, etc., are ineligible for tax-free exchange treatment under this provision. Frequently §1031 is used to exchange real property held for productive use in a trade or business or for investment for property of like kind, i.e., replacement property to be held either for productive use in a trade or business or for investment. The cost for avoiding gain (or loss) recognition under §1031(a) is that the owner of the relinquished property uses the same basis in the replacement property decreased by any money receive and increase by any gain recognized. §1031(d). Other special rules are set forth in the regulations, including rules pertaining to a deferred exchange of property. §1031(a)(3). A deferred exchange will that otherwise qualifies under §1031(a) will in fact qualify where the replacement property: (i) is identified within 45 days of the transfer of the relinquished property; and (ii) such replacement is received by the earlier of 180 days after the transfer of the relinquished property or the due date (including extensions) of the transferor's tax return for the taxable year in which the relinquished property is transferred.

Treas. Reg. §1.1031(k)-1(g)(4) permits a taxpayer to use a qualified intermediary (other than the taxpayer, the taxpayer’s agent or a "disqualified person"), to facilitate a like-kind exchange. Treas. Reg. §1.1031(k)-1(g)(4)(i). If the various requirements in inserting a qualified intermediary as well as the identification (45 days) and replacement period (180 days) requirements are met, etc., the taxpayer's transfer of the relinquished property to a qualified intermediary and subsequent receipt of like-kind replacement property from the qualified intermediary through a third party acquired with the sales proceeds from the relinquished property, is treated as an exchange with the qualified intermediary.

Section 1031(f) provides special rules for property exchanged between related persons intended to qualify under §1031(a). In pertinent part, it provides that if a taxpayer exchanges property with a "related person", that otherwise qualifies as a tax-free exchange under §1031(a), and within 2 years after the date of the last transfer which was part of such exchange the related person disposes or the property or the taxpayer disposes of the property received in the exchange from the related person which was of like kind to the property transferred by the taxpayer, the prior exchange will be fully taxable. As an exception, §1031(f)(2) provides that the related party recognition rule which overrides §1031(a) will not apply where it is established by the taxpayer (transferor of the relinquished property) to the satisfaction of the Secretary that neither the exchange nor such disposition had as one of its principal purposes the avoidance of Federal income tax, and provided that the exchange was not part of a transaction or series of transactions structure to avoid the related party rule in §1031(f).

In Ocumulgee Fields, taxpayer transferred appreciated property to a qualified intermediary (QI) under an exchange agreement in conformity with the requirements under Treas. Reg. §1.1031(k)-1(g)(4), whereupon the QI sold the same property to an unrelated third party and used the sales proceeds to purchase from a "related person" like-kind property that was transferred back to taxpayer to complete the exchange.

The IRS, in assessing a deficiency for the income tax on the gain realized from the taxpayer’s receipt of the replacement property, argued that the exchange was part of a transaction structured to avoid §1031(f) and did not make the "lack of tax avoidance" exception under §1031(f)(2)(C) absent credible proof. The Service viewed the interposition of the QI was to reflect a significant basis shifting in the taxpayer’s holding and an immediate cash out that resulted in substantial tax savings.

The Tax Court agreed with the Service and found taxpayer's claim of "no tax avoidance" purpose unpersuasive and concluded that the end result of actual exchange involving QI was the same as if the taxpayer had made the exchange directly with the related person followed by the related person’s making an outside sale to a third party. In essence the taxpayer failed to carry its burden of proof of the absence of a principal purpose of tax avoidance. In Teruya Bros., Ltd.. & Subs, 124 T.C. 45 (2005), aff’d 104 AFTR 2d 2009 (9th Cir. 9/8/09)

Note: the taxpayer negotiated the sale of relatively low basis real property to an unrelated person through a QI structure, same as in the Ocumulgee Fields case. In anticipation of the sale, the taxpayer arranged to purchase relatively high basis replacement property from a related person. To carry out the transaction, the taxpayer arranged for a qualified intermediary to acquire the property the taxpayer had agreed to sell and to sell it to the unrelated person, to use the proceeds to purchase the replacement property from the related person, and then to transfer that replacement property to the taxpayer. On a related note, Teruya Bros. was just affirmed by the 9th Circuit in upholding the Tax Court’s denial of §1031(a) treatment.

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